REALISTIC EXPECTATIONS

“Life is so constructed that the event does not, cannot, will not, match the expectation.”

Charlotte Brontë

Few people make an investment decision expecting to be disappointed. Every investment ever made, from the Dutch East India Company to Nvidia, was financed by someone with a positive expected return (usually many someones). But how often do investors actually quantify their expectations before the fact? I’ve long thought it would be interesting to ask my investors to write down their expected returns, hide them in a cupboard, and revisit them in a decade. I suspect few of us would be right, including yours truly. That’s not to suggest my partners aren’t good at guessing games, just that the future is stubbornly hard to predict.

I would also hypothesize that the range would be wide but have a central tendency of around 10% (which happens to be the median 10-year return of the Russell 2000 since 1995). If all of us decided to invest in the same strategy, yet have meaningfully different return expectations, would that suggest disappointment is inevitable?

The only cure for disappointment I know is candor, which seldom appears in marketing materials. The asset gathering industry realized a long time ago that you catch more flies with honey than vinegar, so it encourages aspirational thinking (also why their advertisements feature vacation homes, expensive hobbies and boats). People like to feel exceptional, so they let them.

Truth in advertising would go something like this:

·         Your manager will frequently underperform.

·         Their asset class and investing style will go in and out of favor.

·         Demonstrating success may take longer than your holding period.

·         They will receive capital when least advantageous.

I suspect few of you are thinking ‘where do I sign up?’  I’m writing this because I believe a manager attracts the investors they deserve. No one is exceptional all the time, and if your manager encourages this myth, expect disappointment. I’d rather be transparent about my abilities and set modest (but beatable) expectations.

Another reason managers rarely tell investors what to expect is that forward-looking statements expose them to liability, guarantees are all but prohibited and the future is unpredictable. So with a big dose of humility and some iron-clad disclosure, I’m going to describe how I expect Epigram Capital Partners Fund I to perform. Reality may differ materially.

·         The fund may underperform in strong markets. On average, small caps are riskier than large caps and small changes in sentiment cause extreme returns in both directions. After a cyclical bottom, low quality stocks often appreciate rapidly and the strategy could lag. Historically, the predecessor strategy has only captured 71% of the upside of the Russell 2000.

·         The fund may outperform in weak markets. Much has been made of the deteriorating quality of the Russell 2000 index as 42% of its participants are currently unprofitable. Because the predecessor strategy favored established companies with long histories of profitability, it frequently outperformed in down markets, capturing 37% of the downside of the Russell 2000.  

·         The fund is unhedged. Because of my risk metrics, many assume that I short (I don’t). The fund seeks to manage risk by security selection and a willingness to hold cash. The strategy is correlated with stocks (albeit less than most) and strong absolute returns are unlikely in down markets.

·         The fund has concentration risk. The average small cap fund owns more than 100 securities with minimal concentration. This overdiversification reduces volatility and limits the odds of adverse selection. Unfortunately, it also reduces the chances of outperformance. Despite its higher concentration, the predecessor strategy has averaged less than 2/3rds of the index’s volatility.

·         Small caps can underperform for long periods. Small cap performance tends to move in cycles which are often extreme. From 1983 to 1990, the S&P 500 outperformed the Russell 2000 by 91%. 1994 to 1999 was not dissimilar. However, from 1999 to 2014, the Russell 2000 outperformed the S&P by 114%. Small caps have historically performed well during times of economic turbulence, but this may not occur in the future.

·         The fund is index agnostic. Tracking error is a measure of how much a fund differs from its benchmark and implies a wider range of potential outcomes. The predecessor strategy averaged 14% tracking error. This increases the odds that performance differs from the benchmark (in both directions).

·         The fund is willing to hold cash. The predecessor strategy averaged 15% cash since inception and while this reduces volatility, it also limits upside participation.

No manager can tell you how they will perform before the fact. My wife tells me I occasionally mumble ‘past performance is not necessarily indicative of future results’ in my sleep. My aim is to provide differentiated returns with less volatility while exploiting the inefficiencies of small cap investing. As investors increasing opt for passive solutions, I’m trying to preserve what’s best about active management: conviction, opportunism and differentiation. The fund may or may not meet its objectives, but hopefully we’re all on the same page.

Sincerely,

Dan Walker